Pecuniary Externalities

For what it's worth, I think Paul Krugman makes some good points about the problems inherent in using the tax code to encourage or discourage the purchase of health insurance in his column today (original here, reposted here). I obviously don't sign on to his characterizations of "Bush and his advisers," and he stops short of his usual call for a single-payer system, so there's no reason to get into that today.

Were it up to me, I'd completely eliminate the exclusion of health insurance premiums from taxable income. That levels the playing field between premiums and other expenses (as the Bush plan tries to do), but it does so without forcing the tax code to be the arbiter of whether something was a legitimate health expenditure or not. It also raises tens of billions of dollars in additional tax revenue that can then be directed to all the other things the government needs to pay for.

However, I found this statement (highlighted in bold) in Krugman's column to be odd:

While proposing this high-end tax break, Mr. Bush is also proposing a tax increase — not on the wealthy, but on workers who, he thinks, have too much health insurance. The tax code, he said, “unwisely encourages workers to choose overly expensive, gold-plated plans. The result is that insurance premiums rise, and many Americans cannot afford the coverage they need.”

Again, wow. No economic analysis I’m aware of says that when Peter chooses a good health plan, he raises Paul’s premiums. And look at the condescension. Will all those who think they have “gold plated” health coverage please raise their hands?

Is he kidding me? That is almost the definition of a pecuniary externality. Wikipedia describes it as follows:

A pecuniary externality is an externality which operates through prices rather than through real resource effects. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young people in the area to get onto the property ladder.

This is in contrast with real externalities which have a direct resource effect on a third party. For example, pollution from a factory directly harms the environment.

Both pecuniary and real externalities can be either positive or negative.

So in the President's defense, there's a very simple argument to be made here. When one person feels inclined, for whatever reason, to purchase more health care services, that puts upward pressure on the price of health care services (if the supply curve is not flat) and thus the cost to everyone else in the market. Normally, we don't pay any attention to this, because that is precisely the mechanism by which a competitive market achieves economic efficiency.

The President is referring to the pecuniary externality generated by a tax distortion in the treatment of health insurance, which interferes with a market achieiving economic efficiency and thus should concern us. It goes as follows. Premiums are fully excludable from income tax, but out-of-pocket expenses are not tax advantaged. That favors health insurance arrangements in which there are low deductibles and high premiums. Such arrangements can lead to higher utilization of health services, since the insured faces no financial cost at the margin once the low deductible has been met. (This is just a standard moral hazard argument.) Krugman may not believe that the relevant behavioral effects are large here, but he's on shaky ground with his "Wow ... no economic analysis ..." comment.

For more on pecuniary externalities, I came across this source.